Currency movements are capable of wrong-footing even the experts, finds Anthony Harrington. Yet many argue that there are enough predictable patterns to these movements to make currency a valuable asset class
Anticipating movement in currencies is a tricky task. No one gets it right all of the time but currency specialists argue strongly that there are predictable patterns in foreign exchange (FX) which make it an investable asset class with the additional merit of being relatively uncorrelated with stocks and bonds.
At a glance
• The devaluation of the renminbi and the Swiss National Bank’s removal of the euro peg both sent the currency markets into shock.
• Central bank intervention has been a central theme in currency markets for several years.
• The currencies of emerging market commodity producers could bounce back in 2016
• The dollar looks set to continue its climb against the yen.
There were several clear themes in 2015 to take positions on and some of these themes look fairly set to carry into 2016. There have also been a couple of spectacular events that have wrong-footed currency experts. The two that will undoubtedly spring to mind for most FX analysts are Switzerland suddenly ditching its peg to the euro in January and China’s devaluation of the renminbi in August.
Both events sent currency markets into shock. When the Swiss National Bank suddenly removed its euro-franc peg, the Swiss currency gained 30% against the euro in minutes. That is unheard of for a developed world currency pair and it caused market havoc.
China’s devaluation of the renminbi in early August should have been a more modest affair, since the devaluation on day one was only 1.9% against the dollar while a further devaluation a day later still only meant that the renminbi had shifted in total from about 6.1 to the dollar to about 6.4 over the two days, hardly world-shaking in terms of scale. Nevertheless, the world did shake and markets retreated hard in the following days, even though the People’s Bank of China was quick to announce that it had no intention of extending the currency’s devaluation.
Why did the markets react so violently to a relatively slight percentage change? Jeppe Ladkarl, a partner at First Quadrant, says that the reason for the drama was the market perceiving – rightly – that where the renminbi had been highly predictable, the central bank’s devaluation two days in a row signals the end of what had been relative certainty. If it did it once, it could do it any number of times, so traders started factoring in potential ripple effects on global currencies.
“The fundamental point is that China introduced risk into an asset that had had no risk up to that point, so the impact in terms of market infrastructure was large, even though the devaluation was minimal,” he says.
The devaluation also caused strain to radiate out across emerging market Asian currencies generally, at a time when those currencies were already under pressure from the rising dollar. Basically, emerging economies that had gorged on cheap dollar loans in both the public and private sectors did not use the era of cheap money to drive productivity improvements. Today this leaves them in a position where they are paying back loans that are getting progressively more expensive as the dollar appreciates and their currencies depreciate, having largely frittered away the cash bonanza. This is not a good place to be, which is why emerging market yields are rising.
“The fundamental point is that China introduced risk into an asset that had had no risk up to that point, so the impact in terms of market infrastructure was large, even though the devaluation was minimal”
“Some of them [EM commodity currencies] have taken a 15% or even a 20% hit against the US dollar and that looks likely to be partially correcting as we go into 2016. This, in itself, will create further FX volatility”
Of course, central bank interventions have been the central theme in currency markets since they stepped in to prevent the global crash of 2008 from plunging the world economy into another Great Depression. In 2015, the dominant theme affecting the main currency pairs was central bank divergence, with the euro-zone, the UK and the Japan sticking to the ‘loose for longer’ theme and stimulating the markets with quantitative easing (QE), while the Federal Reserve in the US initiated tapering and began talking of the possibility of a slow, incremental upward creep in rates. Not surprisingly, the dollar, as a safe haven currency, appreciated strongly against the euro after the mid-2013 ‘taper tantrum’.
Simon Derrick, chief currency strategist at BNY Mellon, points out that the relationship between currency pairs ultimately reflects the relative growth potential of the underlying economies. Relative economic performance is a fairly long-lived phenomenon, and contributes to the idea that one can talk sensibly about which themes in FX in 2015 are likely to continue into 2016, and which are undergoing change, and that one can do so despite heightened volatility in currency markets.
“We see a lot of opportunities and we think FX is a very important part of the investment universe, and not just a way of hedging out risk”
Since 2008, Derrick points out, underlying economic realities have been heavily mediated by central bank monetary policy decisions, which has, to say the least both complicated and shaped the market’s view of what constitutes ‘fair value’ between currency pairs. The way ‘fair value’ plays in FX is as a mean point. Short-lived macro events can drag the relationship between a currency pair up or down but the FX market has predictable patterns because there is always a pull back to fair value, which parallels the reversion-to-the-mean theory that drives much equity market analysis.
Another important macro theme to set alongside the economic divergence between Europe and the US has been continued weakness in the Chinese economy, where the official GDP growth figures of slightly over 6% are widely questioned, with many analysts suggesting that the real GDP number might be closer to 4% or even lower. This, in turn, has helped to depress commodity prices and has contributed to enduring weakness in the currencies of commodity producers such as the Brazilian real and the Australian and New Zealand dollars.
However, Per Ivarsson, investment partner at Harmonic Capital says that he expects to see some rebalancing of emerging market commodity currencies over the next year. “Some of them have taken a 15% or even a 20% hit against the US dollar and that looks likely to be partially correcting as we go into 2016. This, in itself, will create further FX volatility,” he says.
Picking up on the volatility theme, Russel Matthews, portfolio manager at BlueBay Asset Management, points out that currency markets move in cycles of low and high volatility. The current cycle, which he expects to continue into 2016, is definitely high volatility. As such, pension funds should be looking not just to hedge overseas market exposures, but also to view FX much more as a vital source of well-diversified investment returns in its own right.
“We see a lot of opportunities and we think FX is a very important part of the investment universe, and not just a way of hedging out risk,” he says.
On emerging market currencies, Matthews agrees with Ivarsson that in 2016 these currencies are likely to improve, perhaps strongly. “We see huge potential for investment returns in EM FX. These currencies have been weak since the ‘taper tantrums’ of May 2013 and have had one crisis after another since. It is likely that there is now a great deal of negativity priced in to these currencies, and central bank policies in these countries are adjusting, moving from poor policies to reasonable policies, as a result,” he says.
All that is necessary for a rebound when currencies have been badly beaten down is for markets to see that sensible policies are being put in place and price adjustments follow rapidly. “In Malaysia and Indonesia, for example, the FX market changes have been positive already as we go into the fourth quarter of 2015,” Matthews notes.
The long-term trend for the G7 going into 2016 is for the Fed to move gradually off the zero bound, for the European Central Bank (ECB) to continue further stimulus and for the Bank of England to track the US, with perhaps some lag, he concludes. The euro will continue to be the funding currency of choice, with investors borrowing euros to buy higher-yielding currencies, giving the euro carry trade plenty of life for some time yet.
The dollar-yen is caught up in the same policy divergence theme as the euro-dollar, with the Bank of Japan locked-in to its attempt to generate inflation in an economy that is demographically structured to be deflationary, given the ever increasing ratio of elderly and retired workers to young workers. With the Japanese central bank printing money while the Fed keeps talking of raising rates, the dollar looks set to continue to climb against the yen.
As Ugo Lancioni, head of FX at Neuberger Berman notes, the Bank of Japan has been using all available tools to get the yen down and inflation up. To achieve these goals it has extended its balance sheet massively during 2015 and may well continue this in 2016.
All in all, we seem set for continued high volatility in the currency market through 2016, as BlueBay’s Matthews suggests, which would mean FX movements continuing to get extensive press and public visibility through the coming year. Whether that will be enough to get pension funds thinking more about currencies as an asset class remains to be seen.
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